Michael Fallon confirms that employment rights for shares will lead to new tax avoidance loophole

The Chancellor’s employment rights for shares proposals have rightly been criticised for permitting employees to trade essential key employment rights for potentially worthless shares, undermining both employment protection and the credibility of existing employee share ownership schemes (and the TUC’s comprehensive response makes clear the multiple objectives there are to these ill thought through plans).

But to date the tax implications of the policy have been less well discussed – although emerging evidence suggests they may be significant. There are two key new loopholes that these changes risk opening up.

Firstly, the proposals will make it easier for those who already receive shares as part of a remuneration package to avoid paying tax on them. Capital Gains Tax is currently paid at a rate of 28% (it was increased from 18% in the June 2010 Budget) on all gains (so profit made over the initial value of the shares held) over £10k. In addition, employees who are given shares as part of a pay deal are generally required to pay income tax on any gains they make from any share sales. But under this new scheme, our worry is that those who are currently paid in shares will be classified as ’employee owners’ and then contracted back into the rights they have lost, meaning that the income tax or CGT they would otherwise have incurred on shares worth between £2-£50k (the proposed limits on the scheme) is lost to the Exchequer.

Secondly, and potentially more significantly, under current rules a group of people who set up a new company and then sell it have to pay Capital Gains Tax on the profits they make from the company sale. They are entitled to ‘entrepreneur’s relief’ which means that instead of paying 28% on the gains they make, they are only required to pay 10% (on gains up to £10 million – after which point the higher 28% of CGT applies). But under this new proposal a small start up could choose to classify all founders/directors as ’employee owners’ (and if they wanted contract themselves back into the employment rights they had foregone). At whatever point in the future they then chose to sell the business, they would not be required to pay any tax on any gains.

Some have argued that this loophole could be avoided by preventing ‘connected people’ from accessing the new ’employee owner’ status. This would mean that those ‘connected’ to the owner of a business, e.g. a family member or close friend, would not be eligible for the new classification. But when new businesses are being founded, there is no one to be ‘connected’ to. A new start up cannot, by definition, have any people ‘connected’ to it, as it does not yet exist. So while this type of provision might prevent directors from classifying their partners as ’employee owners’ (subject of course to HMRC having the resources to police the loophole – which, with 10,000 job cuts apparently on the way, seems unlikely) there is nothing it could do to stop founders using the provision. There is therefore huge potential for this new status to provide those starting new businesses with a convenient way to avoid paying any Capital Gains Tax once they sell their companies.

may particularly suit a new business that is being set up by a group of entrepreneurs. They will agree, for example, in that small, tightly knit company, that it would be damaging for the company if one of them started suing the other for unfair dismissal, so they agree to sacrifice some of their rights in return for this kind of added share benefit.

This suggests strongly that not only will this new loophole exist, but that creating it may even be the Government’s intention.

There is no impact assessment available for clause 23 (the clause covering the introduction of the shares for rights scheme) of the Growth and Infrastructure Bill (despite the fact that assessments for all other clauses have now been published), but once one emerges it will be very interesting to consider what the costs of this provision to the Exchequer will be. It is quite possible that the new tax avoidance loopholes that the legislation is set to open up mean that they will be considerable.

Written by Nicola Smith

I’m Head of the Economic and Social Affairs Department at the TUC. I also represent the TUC on the Social Security Advisory Committee. My posts may therefore range from the environment to the welfare state via macro-economic policy but will inevit…